Missing the forest for the trees: Why valuation matters

You can’t see the forest for the trees: It’s a saying as old as time. The thinking goes that you’re so focused on a few things in front of you that you can’t take a step back and see the bigger picture.

In 2017, the trees are U.S. equities—and make no mistake, they’re giant ones, standing tall front and center. The forest is your portfolio.

Yes, U.S. stocks are high. And their related indexes are, in some cases, higher than they’ve ever been. The problem? They’re obscuring investors from peering deeper in—from seeing beyond a short-term time horizon into what else could thrive in their portfolios. Blame it on sentiment and cycle.

All aboard the bandwagon

At Russell Investments, we believe there are three primary forces that drive financial markets: cycle, valuation and sentiment. Cycle refers to the market cycle of peaks and recessions in an economy or in a specific financial market segment. Valuation refers to the worth of an asset class, in comparison to market norms. And sentiment refers to the feeling, or attitude, of investors toward that specific portion of the market.

In the short-term—let’s say within twelve months—we believe that typical market behavior can be attributed to each of these three factors along the following percentages:

Cycle: 40%

Sentiment: 40%

Valuation: 20%

Sentiment is a powerful market driver, and we believe that it’s a primary force driving U.S. equities today. As human beings, we tend to focus on trends. If something is going up, everyone piles on. We find it hard to resist the pull of momentum and go against the grain. This is investing herding behavior at its most basic level.

In our view, cycle is another major factor in today’s market. The better things get, the more people take notice and jump on the bandwagon, and the more the cycle extends.

As a result, we believe that we are in a late-cycle, momentum-driven market—especially in the U.S., where equities have been expensive for years. Sentiment continues to push prices upward, while the business cycle breathes further life into the current market peak. But how much higher can the peaks rise, before we drop toward the valley floor?

Today’s valuation asymmetry: Is it worth the risk?

If cycle and sentiment have pushed the U.S. equity market so high, then looking at the valuation of that market becomes even more critical. The following graph shows that, for U.S. equities, historically when the market has been in the 20% most expensive range, the average future return has only been 4.74% over the next three years. In contrast, the average maximum loss in that same timeframe has been -20.75%. In our view, that’s a lot of risk for minimal gain. Put another way, the bar to overweight U.S. equities in the short term is extremely high. The juice simply isn’t worth the squeeze.

We believe that when valuations become asymmetrical like this, a long-term outlook becomes much more important than a short-term one. In our view, it’s better to give away a little on the upside in the here-and-now than risk losing too much on the downside. This is why we recommend zooming out of the typical one-year time horizon and focusing instead on what’s likely to happen in the next three to seven years. Taking a step back from the giant Redwoods and picturing what the rest of the forest could look like down the road.

Valuation: King of the long-term

If you look out beyond a few years, the importance of valuation becomes far more apparent. This is because within a seven-year time horizon, we’re usually likely to experience an entire market cycle, an entire credit cycle and an entire economic cycle. So, cycle becomes far less important. Likewise, sentiment loses almost all of its significance. Trends die, and sentiment, after all, is the very definition of ephemeral. Beyond seven years, valuation truly is king.

The conclusion? We believe that a significant, short-lived market pullback could occur in the near future, given current valuations and the current market complacency. Mean reversion theory has demonstrated this time and time again. Already, we believe that cycle and sentiment are long in the tooth in their support of U.S. equities. Because of this, valuation for this segment may become more and more paramount—not solely in the long-term, but in the short-term as well. Strategies that identify pockets of value—i.e., hunting for bargains and overlooked assets that have upside—may be the key to protecting the health of your portfolio. At Russell Investments, for instance, we recommend underweighting U.S. equities and focusing instead on European and emerging markets.

We know it’s easy to be tempted by short-term focus and market momentum. Sentiment and cycle urge us to jump on board, to hitch our wagons to today’s sky-high U.S. equities. But we believe it’s not worth it. And valuation agrees with us.

1 Yale Professor Robert Shiller calculates a Cyclically Adjusted P/E Ratio based on stock price divided by prior 10-year earnings. U.S. stock market is represented by an index created by Professor Shiller. The stocks included are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ. Prior to 1926 his data source was Cowles and Associates Common Stocks Index, after 1926 his source has been S&P. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. Average drawdown is the percentage return from period start date to the market trough within the subsequent three years.

Disclosures+

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

Investing involves risk and principal loss is possible.

Past performance does not guarantee future performance.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

This material is not an offer, solicitation or recommendation to purchase any security. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Please remember that all investments carry some level of risk. Although steps can be taken to help reduce risk it cannot be completely removed. They do no not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.

Indexes are unmanaged and cannot be invested in directly.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

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Links to external web sites may contain information concerning investments other than those offered by Russell Investments, its affiliates or subsidiaries. Neither Russell Investments nor its affiliates are responsible for investment decisions with respect to such investments or for the accuracy or completeness of information about such investments. Descriptions of, references to, or links to products or publications within any linked web site does not imply endorsement of that product or publication by Russell Investments. Any opinions or recommendations expressed are solely those of the independent providers and are not the opinions or recommendations of Russell Investments, which is not responsible for any inaccuracies or errors.

Investing in capital markets involves risk, principal loss is possible. There is no guarantee the stated outcomes in the presentation will be met.

This is a publication of Russell Investments. Nothing in this publication is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The contents in this publication are intended for general information purposes only and should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional concerning your own situation and any specific investment questions you may have.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

Links to external web sites may contain information concerning investments other than those offered by Russell Investments, its affiliates or subsidiaries. Neither Russell Investments nor its affiliates are responsible for investment decisions with respect to such investments or for the accuracy or completeness of information about such investments. Descriptions of, references to, or links to products or publications within any linked web site does not imply endorsement of that product or publication by Russell Investments. Any opinions or recommendations expressed are solely those of the independent providers and are not the opinions or recommendations of Russell Investments, which is not responsible for any inaccuracies or errors.

Investing in capital markets involves risk, principal loss is possible. There is no guarantee the stated outcomes in the presentation will be met.

This is a publication of Russell Investments. Nothing in this publication is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The contents in this publication are intended for general information purposes only and should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional concerning your own situation and any specific investment questions you may have.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.